Investing in mutual funds in India is the most popular way for individuals to grow their wealth through a diversified portfolio. Let’s explain the workings of mutual funds by exploring key concepts like Net Asset Value (NAV), expense ratios, load vs. no-load funds, and the role of fund managers in managing the Assets.
What Are Mutual Funds?
Mutual funds in India collect money from multiple investors and invest in diversified portfolio of stocks, bonds, or other securities. This allows an individual investor to access in a diversified investment portfolio managed by professional fund manager without having a lot of capital or deep knowledge of the financial markets
Understanding Net Asset Value (NAV)
NAV is the price per unit of a mutual fund. It’s calculated by taking the total value of the fund’s assets, subtracting its liabilities, and dividing by the number of outstanding units.
Example:
Total assets of the fund: ₹1,000 crore
Total liabilities: ₹100 crore
Number of outstanding units: 50 crore
NAV= ( TOTAL ASSETS – TOTAL LIABILITIES ) / NUMBER OF OUTSTANDING UNITS
= ( 1000cr – 100cr ) / 50cr = 18 rupees
So, the NAV is ₹18 per unit. If you want to invest ₹18,000, you can buy 1,000 units of this mutual fund.
NOTE: Negative NAV : The net asset value(NAV) of a mutual fund is almost never negative but in some cases it is found negative in the following cases:
- Total liabilities exceeds total assets
- Massive market crash
- High leverage ie high borrowing to invest
- Fraud or Mismanagement.
Example :
Total Assets: ₹100 crore (post a significant market downturn)
Total Liabilities: ₹120 crore (due to high leverage and poor investment performance)
Number of Outstanding Units: 10 crore
NAV= ( TOTAL ASSETS – TOTAL LIABILITIES ) / NUMBER OF OUTSTANDING UNITS
= ( 100cr – 120cr ) / 10cr = -2 rupees
Expense Ratios: The Cost of Investing
The expense ratio is the annual fee that mutual funds charge their investors,it is calculated by dividing the total annual expenses of the fund ( including administrative costs, management fees, and other operational expenses) by the average net assets and express it as percentage .
Example:
If a mutual fund in India has an expense ratio of 1.5% and you invest ₹1,00,000, the annual cost would be:
₹1,00,000 * 1.5 % = ₹1,500
This means ₹1,500 of your investment goes towards on fund’s expenses each year which will reduce your overall returns.
Load vs. No-Load Funds
Mutual funds can be classified based on whether they charge a sales commission:
Load Funds: These charge a fee when you buy (entry load) or sell (exit load) units.
No-Load Funds: These do not charge any sales commissions.
Example of a Load Fund:
Entry load of 2%
You invest ₹1,00,000
Commission fee: ₹1,00,000 x 2% = ₹2,000
So, only ₹98,000 is actually invested in the fund.
Example of a No-Load Fund:
You invest ₹1,00,000
No commission fee
The entire ₹1,00,000 is invested in the fund.
The Role of Fund Managers
Fund managers in India take decisions on buying or selling securities based on the fund’s investment objectives. Their expertise and management significantly impact the fund’s performance.
Active Management.
The manager actively selects stocks or bonds to outperform the market.
Passive Management.
The fund tracks an index, like the Nifty 50, aiming to replicate its performance.
Example:
Active Fund: HDFC Equity Fund – The manager selects stocks aiming to beat the benchmark. This fund might have an expense ratio of around 2%.
Passive Fund: SBI Nifty Index Fund – This fund tracks the Nifty 50 index. It might have a lower expense ratio, around 0.20%, because it involves in less active management.
Why to Choose Mutual Funds?
1. Diversification: Spread risk across various investments.
2. Professional Management: Expert fund managers make investment decisions.
3. Liquidity: Easily buy or sell units on any business day.
4. Affordability: Lower minimum investment requirements compared to directly buying stocks or bonds
Conclusion
Understanding the mechanics of mutual funds helps you to take informed investment decisions. By Knowing how NAV, expense ratios, and the differences between load and no-load funds help you in choosing the right mutual fund for your financial goals. If you want to select a fully sound mutual fund by Understanding Mutual Fund Performance Metrics: NAV, Alpha, Beta, and Sharpe Ratio discussed in details in another article. Whether you prefer an active fund aiming for high returns or a passive fund for steady growth, there are numerous options available the market.
